Where was SEC as trouble festered at Chinese companies?

NEW YORK (Reuters) - Alarmed by widening accounting debacles at U.S.-listed Chinese companies, American regulators are scrambling to stem the damage from gaps in laws adopted to protect investors after the Enron scandal a decade ago.

U.S. investors had risked billions of dollars on hundreds of companies based in China - under a belief they were subject to U.S. rules when they sell and list shares in the United States - but a lot of that money has gone up in smoke.

The accounting blowups have humbled some prominent American investors such as top hedge fund manager John Paulson and former AIG CEO Maurice “Hank” Greenberg, spawned lawsuits and prompted a broad investigation by U.S. regulators.

Since March alone, more than two dozen U.S.-listed Chinese companies have announced auditor resignations or accounting problems, and there have been similar blowups in Canada.

Regulators and exchanges also have appeared flat-footed in the face of the growing scandal.

U.S. laws, including the sweeping 2002 Sarbanes-Oxley reform act meant to root out accounting fraud, lose some of their power with Chinese-based entities. The U.S. has no extradition treaty with China and the evidence gathering process in China is impeded by state secrets laws.

“The Chinese accounting problem has been festering for a long time,” said Duke University law professor Jim Cox, who serves on a standing advisory group of the Public Company Accounting Oversight Board (PCAOB), which was set up under Sarbanes-Oxley to oversee accounting firms, including doing thorough inspections of their work.

THWARTED BY STATE LAWS?

“It’s going to get worse before it gets better,” said Cox, who faults the U.S. Securities and Exchange Commission for not taking quicker action.

In particular, he said, the SEC has been slow to tighten oversight of U.S. shell companies acquired by Chinese firms through so-called “reverse mergers” to gain access to U.S. capital markets without having to go through an initial public offering.

SEC officials acknowledged problems with inspecting the accounting records of China-based companies well over a year ago at a meeting of the PCAOB advisory group, he said.

Meredith Cross, head of corporation finance for the SEC, said the agency has stepped up its reviews of Chinese reverse merger firms over the past year.

“We’re currently thinking through whether there is more that we can do,” Cross said.

A year ago, it launched a cross-border working group to review issues with Chinese reverse mergers and other companies with substantial foreign operations.

Officials from the SEC and PCAOB are holding talks with counterparts in Beijing this week in an attempt to get inspection access to Chinese auditors for U.S.-listed companies as one way to get on top of the problem.

But regulators said there is a core problem with tackling the reverse merger question head on because mergers come under state rather than federal law.

“We don’t have a way to say, ‘You can’t do reverse mergers,’” said the SEC’s Cross. “Because the issue of whether someone can merge is not an SEC question, but a matter of state law, it’s not something where we could just wave a magic wand and say, ‘we’re not going to let reverse mergers happen anymore.’”

She did, though, note that such firms were bound by reporting requirements once they were listed.

The SEC also has resource constraints, she said, with about 350 people in its corporation finance division reviewing financial reports of more than 10,000 public companies. It has, though, been devoting more resources to the reverse mergers problem, she noted.

Further complicating matters, the SEC’s Chinese counterpart, the China Securities Regulatory Commission, has no enforcement authority over many of the companies accused of fraud because they only sell shares in the United States.

Like other securities regulators, the CSRC has limited resources, said former SEC chairman Christopher Cox. “When triage is the name of the game, it’s natural that the home country’s priority is protecting its own citizens.”

The SEC has brought several actions against China-based issuers in recent years. In most cases, action consisted of suspending trading or revoking companies’ registration, though more severe penalties were also pursued.

China Energy Savings Technology Inc and its managers were ordered by a federal court in 2009 to pay a $34 million judgment after being charged with a stock manipulation scheme by the SEC.

Chinese courts typically do not enforce U.S. judgments, though at least $4 million will be recovered in that case because the SEC froze assets in the United States.

ACCESS TO WORK PAPERS DIFFICULT

Accounting misconduct fell dramatically in the United States after authorities cracked down on corporate crime in the wake of the Enron and WorldCom frauds. A section of Sarbanes-Oxley that made it a felony for executives to certify false financial statements was one big deterrent.

That provision applies to companies that sell securities in U.S. markets, whether they are based in the United States or another country, but few Chinese executives fear being led away in handcuffs because of the lack of an extradition treaty, lawyers said.

“If you’re a CEO of a company based in China and sign a false Sarbanes-Oxley certification, it’s very difficult for the U.S. government or Justice Department to charge you with that crime, indict you and bring you to justice,” said Phillip Kim, attorney at the Rosen Law Firm. “There are no treaties that provide for that.”

Some Chinese executives resist answering to U.S. authorities at all, auditors said.

“They believe they should not have to respond if they feel any request is too intrusive and believe that they can tell the SEC no,” Mimi Justice, head of Deloitte’s forensic and dispute practice in Orange County, California said at a recent conference in Los Angeles.

Getting auditors’ work papers — crucial evidence in many accounting frauds — has been especially difficult. Many accounting firms would like to hand over records but fear violating China’s state secrets law, attorneys said.

“They have a real dilemma on their hands as to how to respond to the U.S. regulators when to do so might expose them to criminal sanctions in China,” said Alan Linning, a partner at Sidley Austin in Hong Kong.

Crashing share prices and the publicity surrounding them do, of course, have their own Darwinian way of making investors more vigilant. There is, for example, much less appetite for new Chinese listings now, and many of the earlier listings are little more than penny-stock wreckage.

But to some that just begs the question — is the action from the regulators too little, too late?

“I think the public is looking for an SEC that is proactive and in front of these issues, and they have yet to do that in this instance,” said Lynn Turner, a former chief accountant at the SEC.